pp.409–417
AmericanAccountingAssociation
DOI:10.2308/acch-10024
COMMENTARY
FinancialReportingandFinancialCrises:
TheCaseforMeasuringFinancialInstrumentsatFairValueinthe
FinancialStatements
ThomasJ.Linsmeier
SYNOPSIS:TheFinancialAccountingStandardsBoard(FASB)(2010)proposesthatallfinancialinstrumentsbemeasuredatfairvalueinthefinancialstatements.ThiscommentaryprovidesoneBoardmember’sreasoningforsupportingthisproposal,whichisbasedon(1)evidencethattheamortizedcostmodelfailedtoprovidetimelyinformationaboutthedeterioratingfinancialconditionoffailedbanksinthecurrentfinancialcrisis,(2)lessonslearnedfrompriorfinancialcrisesaffectingfinancialinstitutionsintheUnitedStatesandJapan,and(3)researchevidenceindicatingthatfairvaluemeasuresaremosthighlycorrelatedwithbanks’exposurestointerestrateandcreditrisk—twokeyriskexposuresthathaveledtobankfailuresinthethreemostrecentfinancialcrises.
INTRODUCTION
Thekeytosuccessfulbankregulationisknowingwhatbanksarereallyworth.
reeley,Colorado,isaworking-class,ethnicallydiversetownofabout100,000ontheSouthPlatteRiverroughly50milesnorthofDenver.Inearly2009,apillarofitsfinancialcommunity,theNewFrontierBankofGreeley(‘‘WhereAgricultureMeansBusiness!’’),
seemedtobeweatheringtheglobalbankingcrisisinfineform.Throughout2008andinto2009,
ThomasJ.LinsmeierisamemberoftheFinancialAccountingStandardsBoard.
TheauthorappreciatescommentsfromElizabethBlankespoor,BobHerz,LeslieHodder,PatHopkins,JimLeisenring,KathyPetroni,LeslieSeidman,CathyShakespeare,TerryShevlin(editor),EdTrott,andTerryWarfield(associateeditor).
TheviewsexpressedinthispaperarethoseoftheauthoranddonotrepresentpositionsoftheFinancialAccountingStandardsBoard.PositionsoftheFinancialAccountingStandardsBoardarearrivedatonlyafterextensivedueprocessanddeliberation.
G
—CharlesBowsher,U.S.ComptrollerGeneral(1991)
Submitted:December2010Accepted:December2010PublishedOnline:June2011
Correspondingauthor:ThomasJ.Linsmeier
Email: tjlinsmeier@fasb.org
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NewFrontierwascharacterizedas‘‘wellcapitalized’’bybankingregulatorystandards—meaningitstier1risk-basedcapitalratio1wastheoreticallyasolid6percentplus.
OnApril10,2009—amerethreemonthsafterreportingitslastcleanbillofhealth—NewFrontiercollapsedintobankruptcy.ItwasthecostliestbankfailureinColoradohistory,withtheFederalDepositInsuranceFundcoveringlossesof$668.9million.
NewFrontierwasnotaloneinitsrapidreversaloffortune.Ofthe140U.S.banksthatfailedin2009,virtuallyallofthe120withpubliclyavailabledataincommercialbankregulatoryreportingformsshowedsubstantialpositivenetworthontheirbalancesheets.Mostwereconsidered‘‘adequatelycapitalized’’bytheirregulators(Tier1ratiosabove4percent),andmanyeven‘‘wellcapitalized’’justfourtosixmonthsbeforetheycollapsed.
Thespeedwithwhichtheseseeminglyhealthybanksfailedcallsintoquestiontheefficacyofcurrentmeasuresofbankperformanceandfinancialhealth.Thefinancialstatementsthatthesebanksfiledwiththeirregulators—preparedaccordingtoU.S.GAAP—gavelittleindicationoftheirdeterioratingcondition.Anditislikelythatthefinancialstatementsofthe860unnamedinstitutionsasofSeptember2010ontheFederalDepositInsuranceCorporation’s‘‘problem’’banklistdonotlookverydifferentfromtheirpreviously‘‘healthy’’butcurrentlyfailedbrethren.
Aswasthecasenearly20yearsago,whenformerU.S.ComptrollerCharlesBowshertestifiedbeforeCongressontheunfoldingSavingsandLoancrisis,investorsandregulatorsstilldonothaveadequatemeansinthefinancialstatementstodeterminewhatbanksarereallyworth.Thecurrentaccountingmodelforloansandmanyotherfinancialinstruments—theamortizedcostmodel—isbroken.ThemodelfailedtoreflectthedecliningvaluesofassetsheldbybankslikeNewFrontieranditfailedtoconveytherisinglevelsofcreditriskbeingassumedacrossthebankingindustry.Itistimetoconsiderwhetheranewaccountingmodelforfinancialinstrumentscanprovidebettersignalsabouttheperformanceandviabilityoffinancialinstitutions.
HISTORICCOSTSANDFAIRVALUES
Currently,banksarerequiredtorecordthevalueofsomeoftheirfinancialinstruments,specificallyderivativesandmarketablesecurities,atfairvalue,ortheprice(orestimatedprice)theassetwouldfetchuponsaleinanorderlymarket.Theyareallowedtorecordthevalueofotherfinancialinstruments,includingloansandsomedebtsecurities,atamortizedcost—essentiallythehistoriccostatwhichtheywereacquiredororiginated.Thesecostsareadjustedonlywhenmanagementdeterminesthatcreditlossesareprobableorthattheassetsareotherwiseimpaired.Asdescribedlater,inboththemostrecentcrisisandpreviouscrisesinthebankingsector,creditandimpairmentlosses—particularlyonloanportfolios—havebeenconsistentlyanddramaticallyunderestimated.
Anewandbetteraccountingmodelmightrequirethereportingoffairvaluesforallfinancialinstrumentsinadditiontosomehistoricalcostinformation.Thereason:fairvalueinformationprovidesearlywarningstoinvestorsandregulatorsofchangesincurrentmarketexpectationswhenassetpricesaredecliningandrisklevelsforfinancialinstitutionsareincreasing.Historiccostaccountingwithimpairmentestimatesprovidesinsufficientwarningofthesechanges.
Financialinstrumentsarecontractstoeitherreceiveormakepayments.Andbanksareessentiallycollectionsoffinancialcontracts.Thevaluesofthesecontractscanriseandfallrapidlywithchangesinprevailinginterestratesandeconomicconditionsandquicklyalterabank’sfinancialprofile.Theconsequencesofsuchfluctuationshavebeenondisplayoverthepastthreeyears,asthecollateralbackingresidentialandcommercialrealestateloansplungedinvalue,
1Forfurtherexplanationoftermsinitalictype,seetheAppendix.
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simultaneouslydrivingdownthevalueoftherelatedloansanddebtsecuritiesintheportfoliosofU.S.andglobalbanks.
Thecurrentreportingsystemforloansanddebtsecuritiesprovideslimitedinformationaboutthechangingvaluesoftheseinstrumentsinthebasefinancialstatements—andindeedfailedtocapturethedramaticdeclineinvalueinfinancialassetsintherun-uptothecurrentcrisis.U.S.GAAPrequiresthatbanksassessthevalueofthefinancialinstrumentstheycarryatcost,andbookimpairmentchargesagainstthemonlyiftheyhavesufferedeitheranactualoran‘‘other-than-temporary’’lossinvalue.Thisassessmentrequiresjudgment,however,and,asdetailedbelow,therecordofbankmanagersinrecognizinglosseshasbeenexceedinglypoor,asthegenerally‘‘healthy’’balancesheetsofNewFrontierandsomanyotherrecentlyfailedbanksindicate.
Thebestwaytoensurethatregulators,investors,andthemarketatlargehaveafullunderstandingofbanks’truefinancialconditionsistoincludechangesinthevalueoffinancialinstrumentsovertimeinfinancialstatements,alongwithhistoricalcostfigures.Ifwearetoguardagainstunsustainablelendingpracticesthatcanleadtosystemiccrises,fairvalueaccountingshouldbeadoptedforallfinancialinstrumentsaspartofthesolution.
FINANCIALCRISESREDUX
U.S.SavingsandLoanCrisis
Thelimitationsofhistoricalcostaccountingwereglaringlyapparentintheothertwomajorglobalbankingcrisesofthepast25years—theU.S.SavingsandLoan(S&L)crisisinthelate1980sandearly1990s,andtheJapanesebankingcrisisofthe1990sand2000s.
IntheS&Lcrisis,amismatchinthedurationcharacteristicsofassetsandliabilitiesheldbynumerousfinancialinstitutionscreatedasignificantexposuretointerestrateriskthatultimatelyaffectedtheireconomicviability.Asinterestratesrosesharplyinthelate1970sandearly80s,thelongerdurationfixedratemortgageloansheldbymanythrifts—and,toalesserdegree,banks—experiencedsignificantdeclinesinassetvalues.Atthesametime,theshort-termdurationofdemanddepositsprovidedmanycustomersoffinancialinstitutionswiththeabilitytowithdrawdepositstotakeadvantageofhigher-yieldingopportunitiescreatedbyclimbinginterestrates.Inordertoattractorretaindeposits,theseinstitutionswereforcedtoincreasetheinterestpaidtodepositors,furtherhinderingtheireconomicperformanceandfinancialviability.
Theincreaseinfundingcostspaidtodepositorsinducedsomebankstoincreasetheirinvestmentsinriskyassets,ultimatelyresultinginfurtherlosses.Thisaction,alongwiththeliquiditycrunchcausedbydepositorsleavingforhigherreturnopportunities,createdtheconditionsthatledtothefailureofmorethan1,000banksandthriftswithover$500billioninassetsbetween1986and1995.Approximately600othersneededthesupportoftheFederalDepositInsuranceCorporation(FDIC)toremainsolvent.Lossestotaledanestimated$153billion,$124billionofwhichwaspaidbyU.S.taxpayers,accordingtoastudyco-authoredbyaformerchiefintheresearch section at the FDIC (Curry and Shibut 2000).
NumerousreasonsarecitedforthecollapseoftheU.S.thriftindustry:themostsignificantoftheseincludevolatileinterestrates,adverseregionaleconomicconditions—notablyinTexasandthesouthwest—andderegulation.However,magnifyingtheimpactofallthesefactorswasthelackoftransparencyabouttheireffectsonthefinancialhealthoftheseinstitutions.Historicalcostaccountingandconsistentunderestimationoflossesonloanportfoliosprovidedlittlewarningofhowmuchrisinginterestratesandfallingrealestatepriceswereimpactingthevalueofassets,liabilities,andthethrifts’overallfinancialpositions.
In1991,theGovernmentAccountingOffice(GAO)issuedareporton39failedinstitutionsthataccountedforover80percentofthelossesincurredbythebankinsurancefundduring1988
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and1989.Whentheinstitutionswereputinreceivership,FDICinvestigatorsdeterminedthattheseinstitutionshadsufferedlossesof$8.1billionontheirloanportfolios.However,upuntilthepointofinsolvency,thebankshadreportedlossesofjust$1.3billionintheircallreportstobankingregulators. Thus, the GAO (1991) report noted:
Accountingrulesareflawedinthattheyallowbankmanagementconsiderablelatitudein
determiningcarryingamountsforproblemloansandrepossessedcollateral.Recognizingdecreasesfromhistoricalcosttomarketvaluehasanadverseeffectonabank’sreportedfinancialcondition.Thisgivesbankmanagementanincentivetousethelatitudeinaccountingrulestodelaylossrecognitionaslongaspossible.
Thisincentivetodelayrecognitionoflosseswasasstrongintherecentfinancialcrisisasitwas20yearsagointheS&Lcrisis.Itcallsintoquestionwhetheranhistoriccostaccountingmodelthatreliesonmanagementestimatesofimpairmentlossescouldeverberefinedsufficientlytoensureaccurateandtimelyreportingofcreditproblems.2Withoutsuchinformation,neitherinvestorsnorregulatorscanbeexpectedtotaketimelyactiontoinfluencebanks’lendingorinvestmentpracticesto mitigate or prevent broad financial crises in the future. As a consequence, the 1991 GAO reporturgedimmediateadoptionforbothGAAPandregulatoryreportingofmark-to-marketaccountingforalldebtsecurities.Italsosuggestedthatastudybeundertakenofthepotentialmeritsofacomprehensivemarket-value-basedreportingsystemforbanks.Japan’s‘‘LostDecade’’
Thelongerthatlossesgounrecognized,thebiggertheproblembecomesasailingbankscontinuetotakeonnewrisksandunderwritebusinesstheycannotsupport.Historyprovidesanotherdramaticexample:theJapanesebankingindustrycrisisandthatcountry’ssubsequent‘‘lostdecade’’ofthe1990s.
AswasthecasewiththeirU.S.financialinstitutioncounterpartsinthelate80sandearly90s,Japanesebanksdidnotrecognizeintheirfinancialreportsthedramaticlossesthatweremountingonrealestate-backedloansthatbegantofallinvalueinthelate1980s.JapanesebankingregulationallowedthebankstodelaytherecognitionoflossesinhopesthattherealestatemarketandJapaneseeconomywouldrecover.This‘‘delayandpray’’strategywasarecipefordisaster.
TheartificialstrengthoftheJapanesebanks’financialreportsallowedthemtocontinuelending—oftentotheirownailingcustomers.Ina2004reportonJapan’sfinancialcrisis,economistsTakeoHoshiandAnilKashyapnotedthe‘‘consciouspolicyofJapanesebankstokeepextending credit to companies even when the prospects of being repaid are limited’’ (Hoshi andKashyap 2004). The throwing of good money after bad had disastrous consequences for theJapaneseeconomy.Notonlydiditkeepmoney-losing‘‘zombie’’companiesinbusiness,butitcrowdedoutmoreproductivecompetitorsfromthemarket.Italsoledto‘‘zombiebanks,’’sustainedonly by the repeated injection of capital from the government. Hoshi and Kashyap (2004) suggestthattheextendedlifeofthesezombiecompaniesandbankswasamajorfactorbehindthesharpdeclineinproductivitygrowthoftheJapaneseeconomyduringthe1990s.
The dimensions of this crisis are enormous. According to Hoshi and Kashyap (2004), theultimatepricetagtoJapanesetaxpayerscouldbeasmuchas100trillionyen—astaggering20
2In addition to proposing measuring financial instruments at fair value in the financial statements, FASB (2010)proposeschangingthecurrentincurredlossandother-than-temporaryimpairmentmodelsforfinancialinstrumentstoanexpectedlossmodelthatmayresultinearlierrecognitionofimpairmentlosses.Thisproposedchange,however,willnotchangebankmanagers’incentivetodelayrecognitionoflosses.
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percentofthecountry’sGDPandaneconomiccalamitythatcontinuestohobbletheJapaneseeconomy.
OngoingU.S.FinancialCrisis
HowdoesthecurrentU.S.financialcrisiscomparetotheS&LandJapanesecrises?Theeconomiccircumstancesandfinancialreportingissuesaredisturbinglysimilar.Inbothofthepriorcrises,thefailuretorecognizelossesonloansanddebtsecuritiesdelayedrecognitionoftheunderlyingeconomicproblems.Accordingtosubsequentpostmortemanalysesofeachevent,thisfailuredramaticallyexacerbatedthesizeandseverityofthecrisisfortheeconomyandfortaxpayers.AswasthecasewithinstitutionsintheS&LandJapanesecrises,thevastmajorityofU.S.banksthatfailedthelasttwoyears,andthosethataretreadingwaterthisyear,areintroublebecauseofloanportfoliosandrelateddebtsecuritiesthathavedeterioratedinvalue.Thekeypublicpolicyquestioniswhethertheresultingcrisiscouldhavebeenmitigated,orpossiblyevenavoided,hadinvestorsandregulatorsbeenalertedtothisdeteriorationearlier.
Thesevereconsequencesassociatedwiththerecentfinancialcrisisandthetwothatprecededitdemonstratetheimportanceofprovidinginvestorsandregulatorswithaccurateandcurrentgaugesofthecapitalstrengthandoverallhealthoffinancialinstitutions.Theseconsequencesalsodemonstratetheseriousshortcomingsoftheexistingaccountingmodelinthisregard.Underthehistoriccostaccountingmodelwithmanagementestimatesoflosses,reportedshareholderequityandrelatedcalculationsofcapitalratioscapturethedeteriorationinbankcapitalstrengthtooslowlytobeofmuchusetoinvestorsandregulators.
Indeterminingtherisklevelsandcapitaladequacyofbanks,theFDICuses—amongothermeasures—calculationsofTier1Risk-BasedCapitalRatiosandTier1LeverageCapitalRatios.BankswithaTier1Risk-BasedCapitalRatioequaltoorgreaterthan6percentandaTier1LeverageCapitalRatioequaltoorgreaterthan5percentareconsideredtobe‘‘wellcapitalized.’’Bankswithbothratiosequaltoorgreaterthan4percentareconsideredtobe‘‘adequatelycapitalized.’’
Amongthepreviouslydescribed120U.S.banksthatfailedin2009,reportedTier1Risk-BasedCapitalRatiosaveraged6.00percentandTier1LeverageCapitalRatiosaveraged4.87percentforthe12-monthperiodpriortotheirfailure.Alookatquarterlyresultsrevealssteadydeteriorationinaverageratiosastheyearprogressed.However,onaverage,thebankscontinuedtomeetthestandardof‘‘adequatelycapitalized’’inbothTier1Risk-BasedCapitalRatiosandTier1LeverageCapitalRatiosthroughtheperiodjustfourtosixmonthsbeforetheirfailures.Inthesecondquarterpriortofailure,averageTier1Risk-BasedCapitalRatioswere5.14percentandTier1LeverageCapitalRatioswere4.05percent.
OnlyinthequarterimmediatelypriortothefailuresdidtheseratiosslipintotheFDIC’s‘‘undercapitalized’’category.Duringthatperiod,averageTier1Risk-BasedCapitalRatiosforthegroupfellto1.50percentandTier1LeverageCapitalRatiosdroppedto1.23percent.Bythattime,however,itwastoolateforthebanksthemselvestoarrestthedeterioration,forregulatorstodoanythingtosavethem,andforinvestors,depositors,andotherstakeholderstotakemuchactiontoprotectthemselvesfromthethen-imminentfailure.
Buttherewasanothermarket-basedeconomicindicatorthatsignaledpotentialcreditriskproblemsinthebankingindustryatamuchearlierpointintime.TheTEDspread(i.e.,thedifferencebetweentheinterestratesoninterbankloansandshort-termU.S.governmentdebt),whichreflectsthebanks’ownassessmentsofthecreditriskexposureinloansmadetoeachother,spikedfromitshistoricaverageofapproximately30–50basispoints(bps)tonearly200bpsin2007,andtoppedoutat465bpsin2008.Thisshiftconfirmsthatthemarket—andthebanksthemselves—wereawareofsignificantcreditriskproblemsintheindustrylongbeforethesetroublesshowedupinthefinancialstatementsorregulatoryreportsofindividualbanks.
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Asimilarspikeinamarket-basedeconomicindicatoralsoforeshadowedsignificantpotentialriskproblemsforfinancialinstitutionspriortotheS&Lcrisis.Inthelate1970sandearly1980s,interestrateschargedbytheFederalReserveBankincreaseddramatically,withtheeffectiveFederalFundsratepeakingat19.9percentinJuly,1981—arateamongthehighesteverachievedinU.S.history.
NEWFINANCIALREPORTINGMODEL
Thesemovementsinmarket-basedmeasuresrevealchangesintheoverallexposuretocreditandinterestrateriskintheeconomy—twomajorrisksfacedbyfinancialinstitutions.However,theydonotshowhowthoseincreasesinriskaffectindividualbusinesses.Thedepictionofhowchangesinrisksintheeconomyaffectindividualbusinessesistheroleoffinancialreports,anditisthechallengeofaccountingstandardsetterstomaketheeffectsoftheserisksonfinancialinstitutionsmoretransparentinfinancialreportstoinvestorsandothermarketparticipants.
Historiccostaccountingisnotdesignedtoreflecttheeffectsofchangesininterestratesastheyoccur.Infact,itmakesnorecurringprovisionforinterestrateriskatall.Furthermore,theeffectsofchangesincreditriskareonlyreflectedinthehistoriccostmodelthroughmanagement’sestimatesofimpairmentlossesonfinancialassets.Aspreviouslydemonstrated,thesecreditlossestimatesarechronicallyunreliableandoftenvastlyunderstated.Givencriticismsabouttherelevanceandreliabilityoffairvaluemeasures,akeyquestionforstandard-settingpurposesiswhetherfairvalueinformationonfinancialinstrumentswouldbetterreflectthekeyriskexposuresofindividualbanks.3Tworecentacademicstudiessuggestthatisthecase.
One study (Blankespoor et al. 2010) examined the relation between bank credit risk exposures(asmeasuredbyboththeTEDspreadandindividualbankbondyieldspreads)andbankleveragemeasuredundervariousaccountingsystems(fullfairvalueforfinancialinstruments,thecurrentGAAPaccountingsystem,historiccost,andTier1capital).ThestudyfoundthatbankleveragemeasuredunderafullfairvaluesystemisatleastsixtimesmorehighlycorrelatedwiththeTEDspreadthanisleveragemeasuredunderanyotheraccountingmodel,indicatingthatfairvalueinformationgivesamuchmoreaccuratepictureofbanks’financialcondition.ThestudyalsofoundthatTier1RegulatoryCapitalleverageisleastcorrelatedwithbankcreditspreads,suggestingthatthiskeymeasureofregulatorycapitalisleastinformativeaboutcreditconditions.
A second study (Hodder et al. 2006) explored the relation between interest rate risk and thevolatilityofbankincome.Theresultsindicateincomevolatilitymeasuredunderfullfairvalueaccountingissignificantlymoreinformativeaboutinterestraterisk(andothermeasuresofmarketrisk)thanvolatilitymeasuredunderthecurrentU.S.reportingsystem.Again,theseresultssuggestthatfairvalueinformationprovidesabetterdepictionofeconomicposition.
ThesestudiesindicatethatfairvalueaccountingbetterreflectstheperformanceandconditionoffinancialinstitutionsthandoeseithercurrentU.S.GAAPorregulatoryreportingmodels.Themoretimelyandaccuratevaluationofassetsandliabilitiesprovidedbyfairvaluereportingmayhelpinvestorsandregulatorsbetterunderstandanentity’sincreasingexposuretocreditandinterest
3Anotherconcernraisedbycriticsoffairvalueaccountingistheimpactthatitcouldhaveoneconomicstability.Inparticular,thesecriticsbelievethatfairvaluereporting—byrecognizinglossesonatimelybasisindecliningeconomiccycles—mayinducebankstosellilliquidsecuritiestoincreaseregulatorycapital.Thiscouldleadtofurtherdownwardpressureonassetpricesandfurtherdeclinesinreportedassetvalues,ultimatelyexacerbatingthe financial crisis. However, three recent research studies (Securities and Exchange Commission [SEC] 2008;Shaffer 2010; Badertscher et al. 2010) provide evidence that fair value accounting in the recent financial crisis didnotinducesuchprocyclicaleffects.Rather,thesestudiesfindthatfactorsotherthanfairvalue,mostnotablylendingandriskmanagementpractices,werelikelymoreresponsibleforputtingstressonthefinancialconditionofbanks,leadingtothemarkedincreaseinbankfailures.
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raterisksastheyoccur.Inturn,thismaygivethesepartiesmoreopportunitytoinfluenceand/ordisciplinelendingandinvestmentpracticesthatledtotherecentfinancialcrisis.4FASB (2010) is not proposing to do away with the amortized cost model for financial
5instrumentsheldforcollectionorpaymentofcontractualcashflows.Theamortizedcostmodelprovidesusefulinformationaboutthepotentialcashflowsassociatedwiththesefinancialinstruments.Indeed,thedifferencebetweenamortizedcostandfairvaluecapturestheexpectedimpactofcurrenteconomicconditionsonexistingfinancialinstruments.HadthisreportingmodelbeeninplacepriortotheS&Lcrisis,thedifferencebetweenfairvaluesandamortizedcostsarisingfrominterestrateincreaseswouldhaveprovidedearlierwarningsignalsaboutthevulnerabilityofindividualthriftstochangingeconomicconditions.Thisknowledgelikelywouldhavepermittedmoretimelyactionstomonitortheactivitiesoftroubledfinancialinstitutionsandtopromptquickerandless-costlyinterventionbyregulators.
FASB (2010), therefore, is recommending for financial instruments held for collection orpaymentofcontractualcashflowsthatamortizedcostandfairvalueinformationbegivenequalprominenceonthefinancialstatementsand,thus,thatbothmeasuresbemadeavailableforthesefinancialinstrumentsinpublicreleasesoffinancialreportinginformation.Thisdualpresentationinfinancialstatements—whichsomeinvestorshaveaskedfor—wouldensurethatbothrelevantmeasuresaregivenadequateattentionbybanksandtheirauditors.Furthermore,theBoardalsosoonwillberequiring,initsprojecttoconvergefairvaluemeasurementmethodologiesanddisclosureswiththeInternationalAccountingStandardsBoard,newdisclosuresinthefootnotestothefinancialstatementsaboutthemethodologiesandinputsusedtodeterminefairvalues,aswellasinformationrelatingtothemeasurementuncertaintyindiscountedcashflowfairvaluemeasurements(Level3inthefairvaluehierarchy).ThesedisclosureswillhelpinvestorsunderstandandassessthequalityoffairvalueinformationandwillprovideregulatorswithbetterinformationtomakeanyadjustmentstoGAAPreportingthattheydeemnecessaryforregulatorycapitalpurposes.
Totaketimelyactionstohelpmitigateorpreventfuturefinancialcrises,investorsandregulatorsneedtoknowwhatabankisworth.Itistimethataccountingstandardsettershelpthemwithfullfairvaluereportingforfinancialinstruments.
REFERENCES
Badertscher,B.A.,J.J.Burks,andP.D.Easton.2010.Fairvalueaccounting,other-than-temporary
impairmentsandthefinancialcrisis.Workingpaper,NotreDameUniversity.
Blankespoor,E.,T.J.Linsmeier,K.Petroni,andC.Shakespeare.2010.Fairvalueaccountingforfinancial
instruments:Doesitimprovetheassociationbetweenbankleverageandcreditrisk?Workingpaper,MichiganStateUniversity.
Curry,T.,andL.Shibut.2000.Thecostofthesavingsandloancrisis:Truthandconsequences.FDIC
BankingReview13(2):26–35.
FinancialAccountingStandardsBoard(FASB).2010.AccountingforFinancialInstrumentsandRevisionsto
theAccountingforDerivativeInstrumentsandHedgingActivities—FinancialInstruments(Topic825)
45Inexercisingtheirprudentialoversightmandate,whendefiningregulatorycapital,bankregulatorsmaycontinuetomakevariousadjustmentstofairvalue(andother)measuresreportedinU.S.GAAPfinancialstatements.Suchadjustmentsareintendedtohelpensurethesafetyandsoundnessoffinancialinstitutions(seethedefinitionofTier1Risk-BasedCapitalintheAppendixfordetailedinformationoncurrentadjustmentsmadetoU.S.GAAPindefiningTier1capital).However,italsoisdifficultforbankregulatorstoignorefairvalueinformationinfinancialreports,giventhepost-S&Lcrisisrequirement(imposedbytheFederalDepositInsuranceCorporationImprovementActof1991)thattheaccountingprinciplesusedinthereportsandstatementsfiledwithbankingregulatorsbyinsureddepositoryinstitutionsbenolessstringentthanU.S.GAAP.For debt instruments held as assets, the model proposed in FASB (2010) is similar to the model proposed in Trott(2009).
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and Derivatives and Hedging (Topic 815). Proposed accounting standards update. Available at: http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175820761372&blobheader =application/pdf.
GeneralAccountingOffice(GAO).1991.FailedBanks,AccountingandAuditingReformsUrgently
Needed. GAO/AFMD-91-43. Available at: http://archive.gao.gov/d20t9/143697.pdf.
Hodder,L.D.,P.E.Hopkins,andJ.M.Wahlen.2006.Risk-relevanceoffair-valueincomemeasuresfor
commercial banks. The Accounting Review 81 (2): 337–375.Hoshi, T., and A. K. Kashyap. 2004. Japan’s financial crisis and economic stagnation. Journal of Economic
Perspectives 18.1: 3–26.
SecuritiesandExchangeCommission(SEC).2008.ReportandRecommendationsPursuanttoSection133
oftheEmergencyEconomicStabilizationActof2008:StudyonMark-to-MarketAccounting.ReportandRecommendationsPursuanttoSection133oftheEmergencyEconomicStabilizationActof2008: Study on Mark-to-Market Accounting. Available at: http://www.sec.gov/news/studies/2008/marktomarket123008.pdf.
Shaffer,S.2010.Fairvalueaccounting:Villainorinnocentvictim—Exploringthelinksbetweenfairvalue
accounting,bankregulatorycapitalandtherecentfinancialcrisis.WorkingPaperNo.QAU10–01,FederalReserveBankofBoston.Trott, E. 2009. Accounting for debt instruments held as assets. Accounting Horizons 23 (4): 457–469.
APPENDIX
TermsinAlphabeticOrder
Callreports:AllregulatedfinancialinstitutionsintheUnitedStatesarerequiredtofile
periodicfinancialandotherinformationwiththeirrespectiveregulatorsandotherparties.ForbanksintheUnitedStates,oneofthekeyreportsrequiredtobefiledisthequarterlyReportofConditionandIncome,generallyreferredtoastheCallReport.Thesereports,withsomeexceptions,arebasedonU.S.GAAP.
Creditrisk:Creditriskistheriskofalossordefaultonaloan,asset,orlineofcreditbyaborrower.Adefaultonaloancouldincludeafailuretomakeinterestpayments,repaythebalanceoftheloan,oracombinationofboth.Thegreatertheperceivedcreditriskoftheborrower,thehighertheinterestlenderstypicallywilldemand.Othermethodstocompensateforcreditriskincludeprotectivecovenantsinloanagreementswhichmaypledgecertainassetstosecuretheloanorlimittheactions—suchaspayingdividendstoinvestors—thataborrowercanundertakebeforerepayingtheloan.Thecreditriskofaloanincreasesifthefinancialconditionoftheborrowerdeteriorates.
Interestraterisk:Interestrateriskisthevariabilityincashflowsorvaluethataninterest-bearingassetorliability—suchasaloanorabond—canexperienceduetochangesinprevailinginterestrates.Ingeneral,asinterestratesrise,thepriceofafixedratebondwillfall,andviceversa.Theinterestrateriskpertainingtoafinancialinstitutionequalsthecombinedornetriskassociatedwiththeinterestrate-sensitiveinstrumentsitholds.
TEDspread:TEDisanacronymformedfromT-billandED,thetickersymbolfortheEurodollarfuturescontract.TheTEDspreadisthedifferencebetweentheinterestratesonloansbetweencommercialbanks(LIBOR,ortheLondonInterbankOfferRate)andshort-termU.S.Governmentdebt(T-bills).ThespreadisanindicatorofperceivedcreditriskinthegeneraleconomybecauseT-billsareconsideredrisk-freewhileinterbankloanratesreflecttheriskoflendingtocommercialbanks.WhentheTEDspreadincreases,itisasignthatlendersbelievetheriskofdefaultoninterbankloansisincreasing.Interbanklendersthereforedemandahigherrateofinterestoracceptlowerreturnsonsafeinvestmentssuch
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asT-bills.Whentheriskofbankdefaultsisconsideredtobedecreasing,theTEDspreaddecreases.
Tier1risk-basedcapital:Tier1capitalisthecoremeasureofabank’sfinancialstrengthfromaregulator’spointofview.IndefiningTier1capital,thegoalofregulatorswastocreateameasureofthebank’scapitalavailabletoabsorblossesonanongoingbasis.Towardthatend,Tier1capitalistypicallydefinedasshareholder’sequityasreportedunderU.S.GAAP,withvariousadjustmentstoexcludecertainchangesinthefairvalueofassetsandliabilities,mostintangibleassets,andgoodwill.Fairvalueadjustmentstoregulatorycapitalcurrentlyarelimitedtocertaingainsorlossesoncashflowhedges,unrealizedgainsandlossesonavailable-for-saledebtsecurities,andthecumulativeeffectsonliabilitiesofchangesinabank’sowncreditworthiness.Otheritemsrecognizedinthefinancialstatements,suchaspreferredstock,mortgageservicingassets,anddeferredtaxassets,alsoaretreateddifferentlyforregulatoryreportingpurposes.
Zombiebanks:Azombiebankisafinancialinstitutionthathasaneconomicnetworthlessthanzero,butcontinuestooperatebecauseithasimplicitorexplicitgovernmentcreditsupport.ThetermwasfirstusedtoexplainthedangersoftoleratingalargenumberofinsolventsavingsandloanassociationsintheUnitedStatesandlaterappliedtotheemergingJapanesebankingcrisisin1993.
AccountingHorizonsJune2011
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